October 21, 2022
Inflation is a sustained increase in the general price level within an economy.
If the price level falls, then we have Deflation.
The price level going up is not the same thing as one or two prices rising.
Inflation also implies a decrease in the purchasing power of money.
A Price Index is used to measure inflation.
An index is only a number, it is not measured in dollars.
It is the ratio of the average prices in one year relative to the prices in a base year.
There are many price indexes that economists use:
The Consumer Price index is the most commonly used measure.
The CPI is the average price of goods bought by a typical American consumer
The CPI as of September, 2022 is 296.8.
On its own, the CPI doesn’t tell us much. However, it becomes very useful when we look at how it changes over time for:
Inflation is measured using the equation:
\(Inflation\: Rate = \pi = \dot{P} = \frac{P_{t} - P_{t-1}}{P_{t-1}}\)
Where \(P_{t}\) is the average price level (i.e. value of a price index) in year \(t\).
Recall that CPI in September, 2022 is 296.8. The CPI in September, 2021 was 274.3.
Therefore, inflation between those two dates was \(\frac{296.8 - 274.3}{274.3} = 8.2\%\).
CPI is also useful for converting prices between time periods.
A nominal price is a price denominated in the dollar terms of the era the price appeared.
A real price is a price that has been converted into a different time period’s dollars for purposes of comparison
The conversion is simple: \(Real\; Price=Nominal\;Price \frac{CPI_{Target Year}}{CPI_{Original Year}}\)
For example, imagine a product cost $100 in 1972 and $400 today.
While the price of this product has clearly increased in nominal terms, has it increased in real terms? The CPI in 1972 was 41.1.
\(Real\;Price=Nominal\;Price\frac{CPI_{2022}}{CPI_{1972}}=\$100\frac{296.8}{41.1}=\$722.16\)
Therefore, this product has actually become cheaper in real terms: the real price, in current dollars, is \(\$722.16\)!
This graph provides a long-term look at US inflation since the creation of the Federal Reserve.
US inflation rates were far more volatile and had a larger range prior to the 1980s.
The annual inflation rate from September 2021 to September 2022 was 8.2%.
The Federal Reserve worked to drastically cut inflation in the early 1980s.
This is known as the Volcker Disinflation.
The graph on the right shows the much smaller range of US inflation following the Volcker Disinflation.
US inflation spiked following the Covid recession.
The post-Covid inflation peak of 9.1%, recorded in June, 2022 marked the highest inflation rate in the US since November of 1981!
Most developed economies aim to keep their rates of inflation stable and low, with typical inflation targets in the 1% - 3% range.
If low inflation rates are beneficial for the economy, why do some countries have higher inflation rates?
Many governments inflate their currency to fund government deficits or pay off debts.
While this may solve short term budgetary problems, this typically creates far worse long run issues.
Left unchecked, this often leads to hyperinflation. Hyperinflation refers to very high rates of inflation; a common definition is that hyperinflation is when inflation exceeds 50% per month.
Some historical examples of hyperinflation (Hanke and Krus):
| Country | Period | Highest Month (%) | Prices doubled every… |
|---|---|---|---|
| Hungary | 1945-1946 | 41 Quadrillion | 15 hours |
| Zimbabwe | 2007-2008 | 19 Billion | 24 hours |
| Yugoslavia | 1992-1994 | 313 Million | 1.4 days |
| Greece | 1941-1945 | 13,800 | 4.3 days |
| Germany | 1922-1923 | 29,500 | 3.7 days |
| China | 1947-1949 | 5,070 | 5.3 days |
| Venezuela | 2016-2020 | 221 | 18 days |
The worst hyperinflation on record: Hungarian pengo, 1945 - 1946.
An item that would have cost 1 pengo in 1945 would cost 1.3 septillion pengo by the end of the hyperinflation!
Dubious distinction: the largest denomination banknote ever was the 100 quintillion pengo note.
Given the high rates of inflation in the US beginning in late 2021, this question has come back into public discourse.
The classic economics answer comes from Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”
In other words, inflation is determined by the rate at which money is created and spent, and NOT by microeconomic forces.
In the 2021 inflation, politicians and political pundits argued that microeconomic forces were the cause of inflation.
We will see some examples on the next few slides.